Thursday, March 19, 2009

Christopher Carroll with an evidence based rebuttal to the "risk-is-holy
view" advocating a free market, hands off approach to the financial crisis, and
a call for the Fed to do what it always does in a crisis, manage the price of
risk (which means going beyond measures such as the purchase of long-term
government securities and taking risky assets onto the Fed's balance sheet):

Punter of
last resort, Christopher D. Carroll, Vox EU: The financial meltdown that
shifted into high gear last September has flushed into public view many
surprising facts. One of the strangest is the existence, in the economics
profession, of a bizarre religious cult. This cult adheres to the dogma that the
“price of risk” is the Holy of Holies that can properly be set only by the
immaculate invisible hand of the financial marketplace; and cult members seem to
believe, to paraphrase President Lincoln from a rather different context, that
“If the Market wills that the economic crisis continue until every dollar of
economic activity created by the taking of risk shall be repaid by another
dollar destroyed by a newfound fear of risk, so it still must be said that the
judgments of the Market are true and righteous altogether.”

The deep origins of the cult, as always, are obscure; presumably they lie
properly in the field of psychoanalysis. But to the extent that overt origins
can be traced, the wellspring is the literature that attempts to explain the
Mehra and Prescott (1985)
‘equity premium puzzle.’ The ‘puzzle,’ in a nutshell, is that asset prices have
not, historically, exhibited a relationship between risk and return that is easy
to reconcile with the rational behavior of a representative agent facing perfect
markets. Many of the responses to this challenge start with the assumption that
asset prices must be always and everywhere rational, and then proceed
to work out the kind of preferences or environment that can rationalize observed
prices. This game brings to mind Joan Robinson’s comment that “utility
maximization is a metaphysical concept of impregnable circularity,” and Larry
Summers’s remark (quoted by
Robert Waldmann) that the day when economists first started to think that
asset prices should be explained by the characteristics of a representative
agent’s utility function was not a particularly good day for economic science.
Oddly, even the failure of this literature to produce a widely agreed solution
to the ‘puzzle’ does not seem to have weakened participants’ belief in the
soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect
reflect the actual past practice of economic policymaking during crises. As
DeLong (2008)
has recently reminded those of us who are susceptible to the lessons of history
(see also
Kindleberger (2005)),
the “lender of last resort” role of the central bank has always been, during a
panic, to short-circuit the catastrophic economic effects of a collapse of
financial confidence (in today’s terminology, ‘an increase in the price of
risk’).1

Some economists, of course, view narrative history in the DeLong and
Kindleberger mode as irrelevant to the practice of their science; they prefer
hard numbers to mere narrative. For the numerically inclined, however, Figures
1a and 1b should be persuasive; they show that controlling a market price of
risk is something the Federal Reserve has done since it first opened up shop.
The top figure depicts a measure of what we are now pleased to call the
‘risk-free’ rate of interest in the United States – essentially, the
shortest-term interbank lending rate for which data are available (on a
consistent basis) from before and after the founding of the Fed.2
Figure 1b shows the month-to-month changes in this interest rate. The only
reason this rate is now viewed as ‘risk-free’ is that the Fed takes away therisk.3

Figure 1a

Figure 1b

Do the advocates of the risk-is-holy view really believe that we were better
off in a real free-market era when interbank rates could move from 4
percent to 60 percent from one month to the next (as happened in 1873)? And how
long do they think such a system would last? It was, after all, the intolerable
stresses caused by financial panics that ultimately led to the founding of the
Federal Reserve, in the face of adamant opposition from people holding
financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are
eerily similar to dogmas that continue to be propounded today. The panic of
1907, in which J.P. Morgan effectively stepped in as a private lender of last
resort, constituted the last straw for the unregulated financial system that
preceded the managing of risky rates that we have had since the creation of the
Fed.

A less extreme version of essentially the same dogma states that while it is
acceptable for the central bank to suppress the aggregate risk that would
otherwise roil short-term interest rates, the Fed should ignore all other
manifestations of financial risk. It is, if anything, harder to construct a
coherent economic justification of this point of view than of the strict
destructionist view that says the Fed should not exist at all. But there is, at
least, a perception that this way of operating is hallowed by time and practice:
Since the Fed, the story goes, has spent most of its history ignoring risk, it
shouldn’t change that now.

But even this milder dogma does not match the facts. Recent work by Robert
Barbera, Charles Weise, and David Krisch,4
shows that over the “Taylor Rule” era of systematic monetary policy (roughly
since 1984), the Federal Reserve’s choice of the short run interest rate has
been powerfully correlated to market-based measures of risk such as the
difference between the interest rates on corporate bonds and corresponding
maturity Treasuries. When risk has been high, the Fed has felt the need to
stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed’s pattern of past responses to risk and economic conditions (as
embodied in risk-augmented Taylor rules), the implied value of the short term
interest rate right now should be somewhere below negative 3.3 percent (actually
even lower, since these projections do not reflect the dire recent news). Since
interest rates cannot go below zero, the Fed must do something else to boost the
economy. The obvious answer is to do everything possible to rekindle the
appetite for risk – even if that means taking some of that risk onto the Fed’s
balance sheet. This could be accomplished under some interpretations of the
still-evolving TermAsset Lending Facility and has already
happened in the case of some other, bolder, Fed actions that have been properly
viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of
the commercial paper market). How much to buy, and which assets to buy, and how
to minimize the political risks, are all difficult questions. But the danger of
doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond
perhaps some purchases of longer-dated Treasury securities, are not the voices
of reason; they represent a howling dogma that was discredited in 1844 (when the
Bank of England received its first implicit authority to intervene during
panics; see
DeLong (2008)),
was discredited again in the panic of 1907, and again during the Great
Depression (by being adopted in an extreme form), and is in the process of being
discredited yet again today. (In fairness, during ordinary times it is probably
wise for the authorities to avoid attempting systematic manipulation of the
price of risk, for all the reasons
Kindleberger (2005)
and Robert Peel (1844) articulated. But this is no ordinary time).

Let’s put it this way: Simple calculations show that the current price of
risk as measured by corporate bond spreads amounts to a forecast that about 40
percent of corporate America will be in bond default in the near future.5
The only circumstance under which this is remotely plausible is if government
officials turn these dire forecasts into a self-fulfilling prophecy by failing
to intervene forcefully in a way that quells the existential terror currently
afflicting the markets. While I realize that some economists (and some
politicians) might be willing even to undergo another Great Depression as the
steep price of clinging to their faith, those of us who do not share that faith
should not have to suffer such appalling consequences.

As the Economist magazine might put it, the problem is that the
‘punters’ (investors) who normally populate the financial marketplace and risk
their fortunes for the prospect of return, have fled from the field in terror.
Back when the financial system was almost entirely based on banks, the solution
to such a problem was that the Federal Reserve would act as the ‘lender of last
resort’ to quell the panic. In the new financial system where banks are a much
smaller share of the financial marketplace than they once were, the Fed’s
appropriate new role seems clear: It needs to intervene more broadly than
before, in public markets (as has already been done for the commercial paper
market) as well as for banks; it needs, in other words, to step up to the plate
and become the punter of last resort.

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"The Judgments of the Market are True and Righteous Altogether"

Christopher Carroll with an evidence based rebuttal to the "risk-is-holy
view" advocating a free market, hands off approach to the financial crisis, and
a call for the Fed to do what it always does in a crisis, manage the price of
risk (which means going beyond measures such as the purchase of long-term
government securities and taking risky assets onto the Fed's balance sheet):

Punter of
last resort, Christopher D. Carroll, Vox EU: The financial meltdown that
shifted into high gear last September has flushed into public view many
surprising facts. One of the strangest is the existence, in the economics
profession, of a bizarre religious cult. This cult adheres to the dogma that the
“price of risk” is the Holy of Holies that can properly be set only by the
immaculate invisible hand of the financial marketplace; and cult members seem to
believe, to paraphrase President Lincoln from a rather different context, that
“If the Market wills that the economic crisis continue until every dollar of
economic activity created by the taking of risk shall be repaid by another
dollar destroyed by a newfound fear of risk, so it still must be said that the
judgments of the Market are true and righteous altogether.”

The deep origins of the cult, as always, are obscure; presumably they lie
properly in the field of psychoanalysis. But to the extent that overt origins
can be traced, the wellspring is the literature that attempts to explain the
Mehra and Prescott (1985)
‘equity premium puzzle.’ The ‘puzzle,’ in a nutshell, is that asset prices have
not, historically, exhibited a relationship between risk and return that is easy
to reconcile with the rational behavior of a representative agent facing perfect
markets. Many of the responses to this challenge start with the assumption that
asset prices must be always and everywhere rational, and then proceed
to work out the kind of preferences or environment that can rationalize observed
prices. This game brings to mind Joan Robinson’s comment that “utility
maximization is a metaphysical concept of impregnable circularity,” and Larry
Summers’s remark (quoted by
Robert Waldmann) that the day when economists first started to think that
asset prices should be explained by the characteristics of a representative
agent’s utility function was not a particularly good day for economic science.
Oddly, even the failure of this literature to produce a widely agreed solution
to the ‘puzzle’ does not seem to have weakened participants’ belief in the
soundness of the intellectual framework within which asset prices are a puzzle.

Nor does the assumption that asset prices are always and everywhere perfect
reflect the actual past practice of economic policymaking during crises. As
DeLong (2008)
has recently reminded those of us who are susceptible to the lessons of history
(see also
Kindleberger (2005)),
the “lender of last resort” role of the central bank has always been, during a
panic, to short-circuit the catastrophic economic effects of a collapse of
financial confidence (in today’s terminology, ‘an increase in the price of
risk’).1

Some economists, of course, view narrative history in the DeLong and
Kindleberger mode as irrelevant to the practice of their science; they prefer
hard numbers to mere narrative. For the numerically inclined, however, Figures
1a and 1b should be persuasive; they show that controlling a market price of
risk is something the Federal Reserve has done since it first opened up shop.
The top figure depicts a measure of what we are now pleased to call the
‘risk-free’ rate of interest in the United States – essentially, the
shortest-term interbank lending rate for which data are available (on a
consistent basis) from before and after the founding of the Fed.2
Figure 1b shows the month-to-month changes in this interest rate. The only
reason this rate is now viewed as ‘risk-free’ is that the Fed takes away therisk.3

Figure 1a

Figure 1b

Do the advocates of the risk-is-holy view really believe that we were better
off in a real free-market era when interbank rates could move from 4
percent to 60 percent from one month to the next (as happened in 1873)? And how
long do they think such a system would last? It was, after all, the intolerable
stresses caused by financial panics that ultimately led to the founding of the
Federal Reserve, in the face of adamant opposition from people holding
financial-markets-are-perfect, believe-me-not-your-lying-eyes views that are
eerily similar to dogmas that continue to be propounded today. The panic of
1907, in which J.P. Morgan effectively stepped in as a private lender of last
resort, constituted the last straw for the unregulated financial system that
preceded the managing of risky rates that we have had since the creation of the
Fed.

A less extreme version of essentially the same dogma states that while it is
acceptable for the central bank to suppress the aggregate risk that would
otherwise roil short-term interest rates, the Fed should ignore all other
manifestations of financial risk. It is, if anything, harder to construct a
coherent economic justification of this point of view than of the strict
destructionist view that says the Fed should not exist at all. But there is, at
least, a perception that this way of operating is hallowed by time and practice:
Since the Fed, the story goes, has spent most of its history ignoring risk, it
shouldn’t change that now.

But even this milder dogma does not match the facts. Recent work by Robert
Barbera, Charles Weise, and David Krisch,4
shows that over the “Taylor Rule” era of systematic monetary policy (roughly
since 1984), the Federal Reserve’s choice of the short run interest rate has
been powerfully correlated to market-based measures of risk such as the
difference between the interest rates on corporate bonds and corresponding
maturity Treasuries. When risk has been high, the Fed has felt the need to
stimulate the economy by cutting short-term rates, and vice-versa.

Given the Fed’s pattern of past responses to risk and economic conditions (as
embodied in risk-augmented Taylor rules), the implied value of the short term
interest rate right now should be somewhere below negative 3.3 percent (actually
even lower, since these projections do not reflect the dire recent news). Since
interest rates cannot go below zero, the Fed must do something else to boost the
economy. The obvious answer is to do everything possible to rekindle the
appetite for risk – even if that means taking some of that risk onto the Fed’s
balance sheet. This could be accomplished under some interpretations of the
still-evolving TermAsset Lending Facility and has already
happened in the case of some other, bolder, Fed actions that have been properly
viewed as necessary to prevent financial collapse (Bear Stearns; the takeover of
the commercial paper market). How much to buy, and which assets to buy, and how
to minimize the political risks, are all difficult questions. But the danger of
doing too little is far greater, at present, than the danger of doing too much.

The voices that say the Fed should do nothing at all, or nothing beyond
perhaps some purchases of longer-dated Treasury securities, are not the voices
of reason; they represent a howling dogma that was discredited in 1844 (when the
Bank of England received its first implicit authority to intervene during
panics; see
DeLong (2008)),
was discredited again in the panic of 1907, and again during the Great
Depression (by being adopted in an extreme form), and is in the process of being
discredited yet again today. (In fairness, during ordinary times it is probably
wise for the authorities to avoid attempting systematic manipulation of the
price of risk, for all the reasons
Kindleberger (2005)
and Robert Peel (1844) articulated. But this is no ordinary time).

Let’s put it this way: Simple calculations show that the current price of
risk as measured by corporate bond spreads amounts to a forecast that about 40
percent of corporate America will be in bond default in the near future.5
The only circumstance under which this is remotely plausible is if government
officials turn these dire forecasts into a self-fulfilling prophecy by failing
to intervene forcefully in a way that quells the existential terror currently
afflicting the markets. While I realize that some economists (and some
politicians) might be willing even to undergo another Great Depression as the
steep price of clinging to their faith, those of us who do not share that faith
should not have to suffer such appalling consequences.

As the Economist magazine might put it, the problem is that the
‘punters’ (investors) who normally populate the financial marketplace and risk
their fortunes for the prospect of return, have fled from the field in terror.
Back when the financial system was almost entirely based on banks, the solution
to such a problem was that the Federal Reserve would act as the ‘lender of last
resort’ to quell the panic. In the new financial system where banks are a much
smaller share of the financial marketplace than they once were, the Fed’s
appropriate new role seems clear: It needs to intervene more broadly than
before, in public markets (as has already been done for the commercial paper
market) as well as for banks; it needs, in other words, to step up to the plate
and become the punter of last resort.